Mr. Market has so far kept a stiff upper lip in the face of the current fiscal policy debacle. The S&P 500 has only fallen modestly over the past few weeks, and prior to today’s bounce. The benchmark 10-year Treasury note’s yield remains notably below its early September highs. The relative calm displayed in the U.S. markets is occurring even as the federal debt ceiling may be hit seven days from now.

It is always difficult to draw a precise conclusion of what Mr. Market is telling us, and there have been some signs of shaky knees. The VIX, a measure of volatility, recently jumped to levels not seen since last June. Domestic equity mutual funds collectively incurred an estimated $4.1 billion in outflows last week, according to the Investment Company Institute. The last time estimated outflows were anywhere near this range was at the start of last May.

On the other hand, the current price activity does imply a consensus expectation of an agreement on the budget and the debt ceiling will be reached. The difficulty in forecasting what will happen is that there are elected officials who seem more interested in scoring ideological points than being effective leaders. Plus, while the market is forward-looking, it is not always right. The offer by House Republicans to temporarily extend the debt ceiling is a positive step, though we will have to see what is said after this afternoon’s meeting between President Obama and the group of House Republicans. I think an agreement will be reached, but I should stress that I am not a political analyst.

The current fiscal mess is causing systematic risk: The risk one incurs by making an investment (aka market risk). It could be well-argued by both Democrats and Republicans that our economy would be stronger if these fiscal crises did not keep recurring. On the other hand, the recent pullback in stock prices is not unusual given the upward run we’ve had this year. Asset prices don’t move in one direction continuously. More importantly, short-term risks always appear front and center; the bigger risks of not having your assets grow faster than inflation and the potential of outliving your savings are less obvious.

Smart Beta Strategies

Last week, I saw Rob Arnott of Research Affiliates give an interesting presentation on smart beta strategies at the Morningstar ETF Conference. Smart beta strategies use quantitative strategies to weight a portfolio, as opposed to assigning the largest weighting to the companies with the biggest market capitalizations. Advocates, including Arnott, say there is a benefit to placing more emphasis on fundamental factors or seeking lower levels of volatility.

Given the existence of funds using Research Affiliates’ strategies, it would make sense for him to paint the strategies in the best possible light. Yet, Arnott’s presentation showed performance may be improved if the strategies were inverted. In other words, if an investor built a portfolio of stocks using a weighting system opposite of what the smart beta strategy suggests, performance would be as good or better. The problem, however, is that the portfolios would be very bizarre.

Why did the inversion of the strategies work as well or better? Their portfolios did not look like the broad market. This difference helped returns by providing exposure to stocks with smaller market capitalizations and lower valuations. At the same time, these inverse strategies avoided a growth tilt.

The traditional, non-inverted smart beta strategies also benefited from the same characteristics. They are more investable, however, which may allow you to stick with them longer. This is a key point because no matter how good past performance is, a strategy is meaningless unless you are able to consistently stick with it.

The Week Ahead

The U.S. markets will be open on Monday, Columbus Day, but banks will be closed.

Third-quarter earnings season will heat up with approximately 70 members of the S&P 500 reporting. Included in this group are several Dow components: Coca-Cola (KO), Intel Corp. (INTC), and Johnson & Johnson (JNJ) on Tuesday; American Express (AXP) and International Business Machines (IBM) on Wednesday; Goldman Sachs (GS), UnitedHealth Group (UNH) and Verizon Communications (VZ) on Thursday; and General Electric (GE) on Friday.

Economic reports we will see regardless of whether or not the government shutdown continues are the October Empire State survey (Tuesday), the National Association of Home Builders’ October housing index (Wednesday), the Federal Reserve’s periodic Beige Book (Wednesday), and the October Philadelphia Fed survey (Thursday). Reports that could potentially be delayed because of the shutdown are the September Consumer Price Index (Wednesday) and September housing starts and building permits (Thursday).

Dallas Federal Reserve Bank President Richard Fisher and Minneapolis president Narayana Kocherlakota will speak on Thursday.

October stock options will expire on Friday.

AAII Sentiment Survey

Neutral sentiment plunged to a six-month low in the latest AAII Sentiment Survey, as both optimism and pessimism rose.

Bullish sentiment, expectations that stock prices will rise over the next six months, rose 3.5 percentage points to 41.3%. The historical average is 39.0%.

Neutral sentiment, expectations that stock prices will stay essentially unchanged, plunged 7.0 percentage points to 25.1%. This is the lowest neutral sentiment has been since April 18, 2013. It is also just the seventh time in the past 29 weeks neutral sentiment is below its historical average of 30.5%.

Bearish sentiment, expectations that stock prices will fall over the next six months, rose 3.5 percentage points to 33.6%. This is the largest amount of pessimism registered by our survey in seven weeks. The historical average is 30.5%.

This week’s results show an increase in the amount of polarization between those who are bullish and those who are bearish. The ongoing federal budget and debt ceiling standoff are likely contributing to the higher level of pessimism. Giving bullish investors encouragement is the performance of the market, anticipated third-quarter earnings growth and a belief that the debt ceiling will be raised.

This week’s special question asked AAII members if there are any industries or sectors they are avoiding right now. Slightly more than 18% of respondents said they are not avoiding any particular sector or industry. About 12% of respondents said they are avoiding banks and other financial stocks. The uncertainty of raising the debt ceiling was given as an explanation for avoiding these sectors. Commodities were named by 10% of respondents. Retailing stocks and technology stocks were each named by 8% of respondents. Though we did not ask about asset classes, 18% of respondents said they were avoiding bonds, particularly long-term bonds.

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